Read Personalfn's coverage of the latest NFOs

Amortising expenses over several years is a common practice when the expenses have a long standing benefit that is not limited to the year in which it is incurred. The same applies to NFO expenses, which is why they are permitted to be amortised over 5 years.

But Sebi wants to put an end to this practice; it wants the fund house to charge the entire NFO expense in the first year. So why is Sebi being so 'unfair'?

The truth is, Sebi is not being unfair and if it appears that way to fund houses, then they themselves are to blame for Sebi's move. Several factors have influenced Sebi's recommendation to charge the entire NFO expense in the first year. Some of these factors have been highlighted by Sebi itself in the recent past.

It is no secret that despite the horde of NFOs being launched, the industry is seeing very little incremental money enter the system. It's mostly the same money being transferred across schemes. In other words, investors who are already invested in a mutual fund scheme transfer either all, or a portion of the money to the NFO.

This is more popularly referred to as 'churned money'. While it would be normal to expect something like this as a lot of investors have a thing for NFOs because of the Rs 10 NAV, what is not normal is that majority of the money is of the 'churned' variety and there is very little fresh money being attracted by fund houses.

So who is responsible for this?

Like we said, the fund houses are to blame for this. When you give a mutual fund distributor (banks in most cases) as high as 4% upfront commission to raise money for a NFO, you can be sure there is going to be a mad rush to collect that commission any which way.

The upfront is particularly attractive when you consider the fact that if a client stays invested in a scheme for a year, the 'trail' commission is a meagre 0.50-0.75%. If the upfront commission can be collected by tapping existing mutual fund investors and persuading them to switch to the NFO that will be done.

Because gunning for existing clients is easier than educating new clients about the NFO. The latter requires time and effort, which is something of a luxury when you have only three weeks to market an NFO and pocket the 4% commission. So most large distribution houses like banks that are eligible for the high commissions, take the easy route and get churned money into the NFO.

This churned money is also the 'hot money' because it exits the NFO as easily as it entered it. So as more and more NFOs are launched, this money is increasingly churned from one NFO to another. The banks make a neat packet in terms of high commissions and the fund houses breathe easy knowing that they can easily garner significant monies in their NFOs. A typical win-win situation for everyone, right?

Wrong! In this whole discussion about commissions, NFOs, churned money and hot money, we haven't yet got down to discussing the most important element in the system, who in fact should be the raison d'etre of the NFO -- the Investor. The question that we need to ask -- is it a win-win situation for the investor? If you are a long-term investor with a 3-5 year investment time frame, you can be sure you are a big loser in this whole 'drama'.

The big distributor makes a lot of money, the fund house 'apparently' garners a lot of money, the short-term investor is game for some invest-hopping, but what does the long-term investor make? He does not make as much as he would have liked to, because the system works against him. Consider this for a moment.

When you have a lot of short-term investors who are busy entering and existing the mutual fund, it forces the fund manager's hand and makes him resort to short-term investment decisions. This is because he is never really sure when the money will be demanded for redemption.

So he cannot make long-term investment decisions. It disturbs his investment process and clouds his decision-making. Who is the loser in this? The long-term investor, because he is not in the fund for just a few months, but has to suffer on account of the presence of a whole lot of short-term investors.

This also brings us to another point -- about expenses, which is also what got Sebi thinking. If an investor is in the fund for the long haul, why should he carry the burden of expenses on behalf of the short-term investor?

That is why it does not make sense to amortise expenses over five years and unnecessarily burden the long-term investor. Expenses should be charged in the first year of the NFO itself, because that is when a lot of short-term investors exit the fund.

Amortisation makes sense when the benefit of the expense is not restricted to the year in which it is incurred. But when you have a majority of investors exiting within the first year itself, then it is safe to conclude that the benefit is in the first year only and that is when the entire expenses must be charged, as opposed to amortisation over five years.

Apart from introducing an element of evenhandedness between investors, charging expenses in the first year itself can also adversely impact the attractiveness of NFOs. With all expenses being charged to the fund in the first year of operation, the performance of NFOs could look very modest.

This in turn could result in short-term investors and their hot money staying off NFOs, thereby introducing an element of much needed rationality to the NFO phenomenon.

At Personalfn, we recommend NFOs (like all other funds) strictly on merit; also we have chosen to give most NFOs a miss since we found them lacking on that vital parameter. We have realised that a lot of NFOs are targeted more at enhancing the fund house's net asset base, rather than adding value to the investor's portfolio.

In the long-term interest of the investor we believe that it is better to forego commission than to mis-sell an investment. If only the larger distributors like banks had adopted a similar stand, the mutual fund industry would not have been in such a state today.

Here's hoping that Sebi will continue to take up the cause of the retail investor!

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